Debt and the Delusionals

A favorite book of mine remains 'Debt and Delusion' by Peter Warburton, published
in 1999, the book was quickly ushered out of print; but remains a classic 'Financial
Reality Bites' read of a highest order.

Warburton picks up where Paul Volker's triumphant shock therapy had attained
prestigious heights for reigning in the inflationary precipice faced by our
Nation.

In 2000, Volker's reply when queried was telling:

INTERVIEWER: And did you or anybody quite expect how
tough a time it would be with inflation at 20 percent?

PAUL VOLCKER: If you had told me in August of 1979 when
I became chairman of the Federal Reserve Board that interest rates, the prime
rate would get to 21.5 percent, I probably would have crawled into a hole
and cried, I suppose. But then we lived through it.

Governments needed continue to expand well beyond their own financial means
without suffering inflationary widespread consequences. At the time, additional
inflation would have been resisted after President Carter's Secretary of the
Treasury; G. William Miller ran the presses literally non-stop.

After Secretary Miller's foray, the Bond Market would resist inflation, insisting
on higher rates of return. Volker had little choice as market driven interest
rates forced the Central Bank to follow with rate increases of its own in order
to contain an expanding Monetary Base.

Volker had two choices: total destruction of the Dollar through accelerating
inflation or raise rates and raise them aggressively. This series of Rate Hikes
was a likely contributing factor to President Carter loss in the 1980 election.

If Government were to ever again attempt to expand under an Inflationary ruse,
a dilemma needed to be resolved: a change in the very nature of financing Government
debt.

Deficits would need to be financed through bonds sold to private investors
through existing Financial Markets. This would place the bonds in the hands
of Investment funds, rather than on the books of commercial banks as would
have been the case had they returned to the old style of monetization under
the old regime.

Consider the explosive growth of this new diversionary tactic over the course
of the closing of the Gold Window through 2002:

1971 = $1 Trillion

1994 = $ 23 Trillion

2002 = $ 43 trillion

In addition to the new issuance of Bonds to fund deficits, the Government
saw fit to extend its tentacles through General Ledger 'Trust' surpluses which
have been raided wholesale. 'Savings' within the Social Security 'Trust' are
continually replaced with Government Debt. The 'Piggy Bank' is running dry
as the amount swapped from the Social Security Trust Fund has exceeded $1.5
Trillion, with an additional 1.6 Trillion swapped for Government Bonds from
other 'Trusts.' These 'swaps' continue to mask Government Deficit Spending.

Suggesting 'Budget Surpluses" even exist, as President Clinton did, is laughable.

Dilemma solved.

The Government Bond Issuances 'Tsunami' has washed ashore upon every Capital
beachhead, yet interest rates have been driven to historic lows and remain
decidedly negative in real terms. Real Rates are far lower now than in 1971
when we had to carry $1 trillion on the Governments Books and with the Personal
Savings Rate on the decline it is apparent 'Savings' from outside the United
Stated is carrying the burden.

After Friday morning's farcical BLS statistics, I choose to spend the balance
of the day reviewing the most recent Bank of International (BIS) Settlements
Data on Derivatives.

Exchange Traded Derivatives now total $279 trillion

OTC derivatives now total $220 trillion

Combined we have reached one Billon Dollar shy of a Quadrillion Dollars, or
$500 Trillion.

I managed to contact various members of the BIS, NY Fed, General Accounting
Office (GAO) and several Committee Members from a prestigious think tank reviewing
both Monetary & Fiscal Policies since 1993, the FER.

What I confirmed was illuminating.

There are appeared to be a consensus among several of those willing to express
'Value Judgments' beyond the typical bureaucratic statistical pabulum.

Primary concerns focused primarily upon two factors:

1. Derivatives do not themselves create 'Value.'

2. Over the Counter Derivatives should be 'Regulated'

In discussing Interest Rate Swaps I began to query the GAO's own statistics
for underlying 'Fair Value' to notional amounts reported. By the GAO's own
metrics these 'Values' or "Money at Risk' account for between 5 to 7% of the
'Notional Values' stated in the BIS report. Given a very high percentage of
these instruments are 'Interest Rate Swaps' we can make some simple assumptions
regarding the underlying 'Money at Risk.'

Of the $499 Trillion in combined Derivatives, $24.95 - $34.93 Trillion is
'Money' at 'Risk' as 'Fair Value' underlying the TOTAL Notional Amount of $499
Trillion.

These figures are simply staggering. It is important to note that although
Exchange Traded Derivatives are regulated, OTC derivatives are not and in fact
many OTC derivatives can go unreported.

Essentially, the $220 Trillion figure in the BIS release does not account
for non-reporting and is therefore low.

In my opinion, Derivatives represent nothing more than a wealth transfer mechanism,
a shifting of risks associated with Credit expansion. If the scope and scale
of underlying 'Fair Value, Money or Capital' at 'Risk,' one has to question
who has the ability to structure such vehicles for transfer.

Securitization is the process of creating a marketable asset by assembling
together a basket of smaller Financial Instruments. An extraordinary number
of Financial Products have been so structured because doing so allowed the
velocity of credit to increase.

For instance, through the sale of these baskets, no longer would a bank be
limited in its ability to lend money and aggregate profits. A small bank would
be able to originate a conforming loan to aggregation standards thereby allowing
that loan to be combined with other similar loans in a product called a mortgage
backed security.

These products have allowed US Debtors to leverage Asian savings. Problems
being that savings must find a risk adjusted return on investment. The risk
component of the equation was totally ignored. MBS, CDO, Reinsurance and other
terms are used to describe these products.

The underlying risk assumptions of these products are flawed. The point of
these products was to sell a product, a product reliant on an ever increasing
'Velocity of Credit.' As Credit contracts the flaws Monetary and Fiscal Policies
become apparent within the Business Cycle.

Thus, the IMF continues to widely promote Structured Finance and Securitization
to Financial intermediaries, Corporations and Governments to transfer risk
with little regard for Financial Stability. At present we are witnessing the
greatest transfer of 'Risk' in recorded History.

We are dealing with leveraged risk, amplified risk. The velocity of credit
has grown to such levels that the monies involved eclipse the real physical
and tangible economy. With the US at the nexus of the global financial economy
profits rely entirely on structured finance. The Asians, namely Japan on the
other hand, are the holding the bag.

GINNIE MAE, FANNIE MAE & FREDDIE MAC (Agency) Securitization of Residential
Mortgages represent the greatest threat to our highly leveraged Capital Stock.
The U.S. 'Wealth' is obtained as the sum of the domestic stock of Capital plus
the International Investment Positions. The chart in Figure 001 illustrates
the explosive growth in MBS activity in the United States.

Figure 001: RMBS Activity 1980 - 2004

The United States Current Account balance from 1971 - 1982 (The net flow of
current transactions, including goods, services, and interest payments, between
countries) as a share of U.S. GNP; averaged approximately zero.

Gross National Product (GNP) is the total dollar value
of all final goods and services produced for consumption in society
during a particular time period. Its rise or fall measures economic activity
based on the labor and production output within a country.

An important distinction needs to be observed between NGP & GDP.

Gross Domestic Product (GDP) measures output generated
through production by labor and property which is physically located within
the confines of a country.

Beginning in 1983, however, the United States experienced increasingly large
current account deficits, which reached 3.4 percent of GNP in 1987, coincidentally,
on October 19th, 1987 the stock market crashed. The DJIA closed down 22.6%
for the day.

October of 1987 had been a highly volatile month, there were warning signs
flashing that provided clues as to what was coming with both the Dollar and
Bond Markets volatility.

After the 1987 'Crash' the trend toward larger deficits gradually reversed
during the rest of the 1980's, and by 1991 the current account was approaching
zero once again.

Beginning in 1993 the Current Account began to trend towards increasingly
large Current Account Deficits, which grew to 4.4 percent in 2000 and presently
stand at approximately 5.75% according to U.S. Federal Reserve Governor Ben
S. Bernanke. This trend, as illustrated below in Figure 002 corresponds with
a dramatic decline in Personal Savings.

The change in trend of the Current Account is a warning, pure and simple.

The United States consumes more of the world's output than it produces.

We import more goods than we export and in exchange for these imports, we
provide our trading partners with financial claims against our own future output.

The United States Dollar's Seignorage restricts the prospects of Foreign Diversification.

It is important to understand the nature of how our Capital Stock was raided,
inflated and used to offset the decline our Rate of Savings. Every component
of our Capital Stock has been inflated to create the illusion of a "Wealth
Effect." No where has this effect been more profound than in the accumulation
of value in home equity.

The 'Wealth Effect' has had and continues to have a measurable effect on consumer
behavior, the greatest cause / effect has occurred within Residential Real
Estate.

The prior Asset Inflations of Capital Stock have failed. The Nasdaq / Dot
Com / New Economy bubbles blew themselves to smithereens in short order. The
Fed's willingness to continue perpetrating its 'Moral Hazards' finally extended
to real Estate.

The Federal Reserve understands all to well the very nature of 'Credit Cycles'
and there inherent risks, they opted for a furthering of the cycle expanding
it to the most underutilized component of 'Personal Savings,' the American
Home.

Figure 002: Personal Savings

The Federal Reserve has the above data represented in Figure 002 in real time
and prepares well in advance of the Primary Trend Illustrated above. By mid
1992 Personal Savings began to diminish as the 'Financial Economy' began to
take hold.

Clearly, the Residential Mortgage Market was the most egregious form of Asset
Inflation and Securitization the Federal Reserve.

Monetary Policy was both good for the goose and its shareholder gander. It
was a win / win for the Fed as they injected massive 'Financial Economic Activity'
while the rest of the economy continued to be starved for Capital. Business
did not accept the 'Greenspan Moral Hazard,' they began reducing Capital investments
with Nominal interest Rates at historic lows.

Evidently enough, the Residential Mortgage market is one of the most fraudulent
applications of securitization, judging by the level of accumulated Agency
Activity at Fannie Mae, Freddie Mac and Ginnie Mae, the risks are astronomical.

Figure 003: Real Estate Fixed investment

The Savings Rate is important as saving provide the Capital for Investment
which expands Economy Activity, this should not be confused with the fictitious
'Wealth Effect.' We are presently observing the effects of this mal investment
take hold in my opinion. The very nature of this Credit Cycle's scope and scale
are far too massive to accurately project what a very real and approaching
contraction will look like, other than to say it won't be pretty and will most
likely resemble an environment of chaos and instability, both financially and
socially.

As the pace of Securitization accelerates while Agencies attempt to transfer
risks to the Retail Public, we need to keep a close eye upon the Financial
Markets ability to digest this process.

Increasingly, it is fraught with peril for both Lenders and Borrowers, a potent
combination.